How US Interest Rates Move the World Economy

Because America has the world’s largest economy, every economic move that the United States makes has immediate effects on the global markets. In 2022, the U.S. is raising interest rates and there are concerns about ripple effects throughout the rest of the world.

At a basic level, raising interest rates go hand-in-hand with appreciating currencies. And in many parts of the world, the U.S. dollar is used as a benchmark of current and future economic growth. In developed countries, a strong dollar is seen in a positive light. But circumstances are different in emerging economies. 

Key Takeaways

• Rising interest rates correspond with appreciating currencies.

• When the U.S. raises interest rates, there are concerns about its global effects.

• The value of Treasury Bonds correlates to changes in U.S. interest rates.

• U.S. dollar-denominated liabilities at global banks have been steadily increasing.

• A strong dollar that accompanies a rate increase often boosts U.S. demand for products around the world.

The Appreciating Dollar

In the aftermath of the 2008 Financial Crisis, the Federal Reserve implemented years of quantitative easing to stimulate economic recovery, slashing rates to a near-zero, where they remained for the next six years. The idea was to spur investments, along with consumer spending, and drag the American economy out of recession. In the years that followed, the economy did begin to recover.

Following the COVID-19 pandemic and the significant increase in inflation, the Federal Reserve is raising interest rates once again in 2022. Historically, rising interest rates have gone hand-in-hand with an appreciating U.S. dollar. This, in turn, affects economic facets domestically and around the world—particularly the credit market, commodities, stocks, and investment opportunities.

Treasury Bonds

The value of U.S. Treasury Bonds is directly connected to changes in U.S. interest rates, and in the United States, the Treasury yield curve is quick to reflect changes in domestic interest rates. As the yield curve moves up or down, global rates are set, accordingly. Since Treasury bonds are considered a risk-free asset, any other security must offer a higher yield to remain attractive, and with interest rates expected to increase, causing global investors to park their money in the U.S., emerging markets will feel a great deal of pressure to remain attractive. Ultimately, this could hinder employment levels in developing nations, along with exchange rates and exports.

Dollar Denominated Debt

Emerging markets are commonly affected by increasing interest rates in the United States and dollar appreciation. U.S. dollar-denominated liabilities at global banks have been steadily increasing and are the highest among major international currencies, with a balance of over $15 trillion in 2021. Countries such as Turkey, Brazil, and South Africa, which perpetually run trade deficits, finance their account deficits by building up dollar-denominated debt. In situations where U.S. interest rates increase while the dollar appreciates, the exchange rate between developing nations and the United States tends to widen. As a result, dollar-denominated debt owed by developing nations increases and becomes unmanageable.

The Credit Market

The fear of rising interest rates can be rooted in their contractionary effects on credit and money supply. Basic economic theory attests that higher interest rates lead to a decrease in the money supply and appreciation of the dollar. At the same time, lending and credit markets contract. Global credit markets follow the movements of Treasury Bonds. And, as interest rates increase, the cost of credit does, too. From bank loans to mortgages, it becomes more expensive to borrow. Hence, an increase in the cost of capital can hinder consumption, manufacturing, and production.

The most profound consequences of interest rate hikes in America are likely to come at the expense of Asian economies, accelerating capital outflows from China and creating more instability in that nation, which is already experiencing financial turbulence. Historically, China has borrowed from foreign banks to stimulate growth. This borrowing was fueled by lower interest rates. But with tighter credit conditions looming, foreign lending to heavily indebted countries will drop off significantly.

The Commodities Market

Oil, gold, cotton, and other global commodities are priced in U.S. dollars, and a strong currency following a rate increase would increase the price of commodities for non-dollar holders. Economies that rely primarily on commodity production and an abundance of natural resources will be worse off. As the products of their principal industrial decline in value, their available credit streams will shrink.

Foreign Trade

Despite how U.S. interest rates negatively impact the global economy, rising interest rates do benefit foreign trade. The stronger dollar that will accompany the rate increase should boost demand for products around the world, increasing corporate profits for domestic and foreign companies alike. Because fluctuations in the stock market reflect beliefs about whether industries grow or contract, the resulting profit spikes will lead to the stock market will rallies.

The Bottom Line

Interest rates are fundamental indicators of an economy’s growth. In the United States, the Federal Reserve’s move to increase interest rates is expected to spur growth and exuberance on the part of investors, while tempering the economy itself. Higher interest rates can help an economy avoid overproduction traps and asset bubbles fueled by cheap debt. While the Fed’s primary concern is the U.S. economy, it will also be paying close attention to the effect its rate increase will have on foreign trade, and the world's credit and commodities markets.         

Article Sources
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  1. Federal Reserve Bank of New York. "The U.S. Dollar's Global Roles: Revisiting Where Things Stand."